Investors do a whole lot of things to save their money when investing and trading in stocks. One such strategy is the protective put strategy. It is a simple and smart way to insure your stocks. When you buy a put option on a stock you own, it allows you to sell the stock at a certain price even if the stock’s value drops. This way you would not lose as much money even if the market is down.
In this brief guide, understand what is protective put strategy, how it works, and how you can use it. Also, learn some variations of the protective put strategy.
What Is Protective Put Strategy?
The protective put strategy is all about buying a put option for a stock that you own. When you have a put option for your stocks, you can sell them at a fixed price, often called the strike price, before a specific date. It is used by investors as it gives them the opportunity to sell their stock at a better price even if the market falls, thereby reducing their loss.
How Does the Protective Put Strategy Work?
Here’s how the protective put strategy works:
- First, you own a stock or shares of a company.
- Next, you buy a put option for that stock. This would give you the right to sell the stock at a certain price irrespective of the market condition.
- If the stock price goes up, you do not need the put option anymore. You can just let it expire and enjoy the profits.
- If the stock price falls, you can use the put option to sell your stock at the strike price and eventually reduce your loss.
Advanced Aspects of Protective Puts
You can also take advantage of a protective put option strategy and choose the optimal strike price and expiration timing to improve the chance of profits. Here’s how you can go about it:
- Strike Price Selection: Choose a strike price that is close to the current stock price as it would offer better protection, though it would cost more.
- Expiration Timing: Shorter expiration times usually cost less, however, they offer protection only for a limited period. If you go with longer expiration times, then you can avail protection for a longer time, though it would cost more. So, you should always choose the expiration based on how long you think the stock might be at risk of dropping.
Protective Put Performance Vs. Naked Long Positions
Simply holding the stock without any protection is called a naked long position. Let’s compare it to the performance of a protective put strategy to understand better.
- With Protective Put: If the stock price falls, the put option would limit how much you can lose. This is safer as you would be having insurance against a big drop.
- Naked Long Position: If you only hold the stock without protection, you could lose a lot if the stock price falls sharply.
So, it can be said that a protective put option strategy helps you balance risk.
Variations of Protective Put Strategies
Synthetic Protective Put Strategies
A synthetic protective put is a combination of different financial instruments like futures and options without actually buying the put option. This can be cheaper than a traditional protective put.
Let’s understand it with an example:
Using futures, you can combine owning the stock with a future contract, and this would help lock in a selling price. Using options, you can create a synthetic protective put by buying a call option and shorting the stock at the same time.
Ratio Put Spreads
A ratio put spread is another variation where you buy a put option and sell multiple put options at lower strike prices. This helps make buying the put option cheaper as the money you get from selling extra put options helps cover some of the cost. It is perfect for investors who expect moderate price declines but still wish to have some protection.
When to Use Protective Put Strategy?
You can use the protective put strategy if the stock market is volatile or there is uncertainty. You can also consider it if you have a large investment in a single stock and want to protect it from big losses.
Pros and Cons of the Protective Put Strategy
Pros
- Protects your investment by limiting losses if the stock price falls.
- You can still benefit if the stock price rises.
Cons
- Buying a put option comes with a cost, which reduces your overall profit if the stock price rises.
- The protection only lasts until the option expires.
Conclusion
So, the protective put strategy is like having insurance for your stocks. It would help you protect your money while still providing you with profit if the stock goes up.
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Also Read: Understanding the Open High Open Low (OHOL) Strategy: Meaning, Examples, and How It Works
